Attilio Meucci

(Re)Defining and Managing Diversification

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A. Meucci – Factor-based Portfolio Management Modern Portfolio Theory

Standard approach: Modern Portfolio Theory

Optimal Portfolio = optimal mean-variance weights

under constraints
A. Meucci – Factor-based Portfolio Management Modern Portfolio Theory

Standard approach: Modern Portfolio Theory

Portfolio Return = weighted average of asset returns

Optimal Portfolio = optimal mean-variance weights

under constraints
A. Meucci – Factor-based Portfolio Management Modern Portfolio Theory

Standard approach: Modern Portfolio Theory

Portfolio Return = weighted average of asset returns

Optimal Portfolio = optimal mean-variance weights

under constraints

vector of expected asset returns matrix of asset covariances

A. Meucci – Factor-based Portfolio Management Factors and Premia

Trend 1: From asset-based allocation to factor-based allocation

Optimal Portfolio = optimal mean-variance

A. Meucci – Factor-based Portfolio Management Factors and Premia

Trend 1: From asset-based allocation to factor-based allocation

Portfolio Return = Linear factor model

(factors: momentum, value, …,PCA,…
strategies,…)

Optimal Portfolio = optimal mean-variance

A. Meucci – Factor-based Portfolio Management Factors and Premia

Trend 1: From asset-based allocation to factor-based allocation

Portfolio Return = Linear factor model

(factors: momentum, value, …,PCA,…
strategies,…)

Optimal Portfolio = optimal mean-variance

exposures under constraints
A. Meucci – Factor-based Portfolio Management Factors and Premia

Trend 1: From asset-based allocation to factor-based allocation

Portfolio Return = Linear factor model

(factors: momentum, value, …,PCA,…
strategies,…)

Optimal Portfolio = optimal mean-variance

exposures under constraints

vector of factor premia matrix of factor covariances

A. Meucci – Factor-based Portfolio Management Diversification: risk “contributions”

Trend 2: from mean-variance to risk parity, or diversification management

Portfolio Return = weighted average of asset returns

“contributions” to risk
A. Meucci – Factor-based Portfolio Management Diversification: risk “contributions”

Trend 2: from mean-variance to risk parity, or diversification management

Portfolio Return = weighted average of asset returns

Optimal Portfolio = equal “contributions” to risk

“contributions” to risk

matrix of asset covariances

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Portfolio Return = weighted average of asset returns

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

if correlations = 0

security number
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

if correlations = 0
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

PCA

eigenvectors

eigenvalues
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

PCA

eigenvectors

uncorrelated, maximum
variance portfolios

eigenvalues
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

PCA

eigenvectors

uncorrelated, maximum
variance portfolios

eigenvalues

variances of uncorrelated,
maximum variance portfolios
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

PCA

eigenvectors

principal portfolios

eigenvalues

principal variances
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

PCA

principal portfolios

principal variances
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

return of principal portfolios

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

return of principal portfolios

weights of original portfolio on principal portfolios

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

Σ ≡ Cov {R}

return of principal portfolios

weights of original portfolio on principal portfolios

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

total
variance variance concentration curve

principal portfolio number

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve

contribution to original portfolio variance from n-th principal portfolio:
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

total
volatility volatility concentration curve

principal portfolio number

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve


volatility concentration curve
contribution to original portfolio volatility from n-th principal portfolio: “hot spots”
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

diversification distribution
1

0
principal portfolio number

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve


volatility concentration curve

diversification distribution
contribution to original portfolio r-square from n-th principal portfolio
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve


volatility concentration curve

diversification distribution
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets

diversification distribution
1

principal portfolio number

0

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve


volatility concentration curve

diversification distribution: “probability mass”
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets
effective number of bets


diversification

return of principal portfolios

weights of original portfolio on principal portfolios

variance concentration curve


volatility concentration curve

diversification distribution: “probability mass”
A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets
effective number of bets full concentration

weights

diversification distribution: “probability mass”

A. Meucci – Factor-based Portfolio Management Diversification: Effective Number of Bets
effective number of bets full concentration

full diversification

weights

weights

diversification distribution: “probability mass”

A. Meucci – Factor-based Portfolio Management Diversification management
effective number of bets full concentration

full diversification

mean-diversification frontier
weights

weights
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

???
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

Factor-based Risk Parity

A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

i) Factors on Demand: best portfolio-specific linear factor model

A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

i) Factors on Demand: best portfolio-specific linear factor model

ii) Minimal Torsion Bets: , uncorrelated factors closest to factors

Original Factors
Minimum-Torsion Bets
Principal Components Bets
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

i) Factors on Demand: best portfolio-specific linear factor model

ii) Minimal Torsion Bets: , uncorrelated factors closest to factors

Riccati root of correlation

A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets

i) Factors on Demand: best portfolio-specific linear factor model

ii) Minimal Torsion Bets: , uncorrelated factors closest to factors

Riccati root of correlation

ii) Diversification Distribution and Effective Number of Minimum

Torsion Bets
A. Meucci – Factor-based Portfolio Management
Effective Number of Bets
(normalized)

1
Weights / Probabilities

Minimum-Torsion
Diversification Distribution

Portfolio Weights
A. Meucci – Factor-based Portfolio Management Minimal Torsion Bets: Case Study

The Effective Number of PCA Bets in The Effective Number of Minimal

the S&P500 is close to 1, since the Torsion Bets in the S&P500 yields
first PCA factor loadings are similar intuitive results
to the weights of the stocks in the
S&P500
Number of Bets = ENB/N
Normalized Effective

Minimum-Torsion

Principal Components
A. Meucci – Factor-based Portfolio Management

Marginal Contributions
Weights / Probabilities

Portfolio Weights
A. Meucci – Factor-based Portfolio Management Next Steps: Minimal Torsion Bets
A. Meucci – Factor-based Portfolio Management References

Effective Number of Bets: http://symmys.com/node/199

Factors on Demand: http://symmys.com/node/164

Minimal Torsion Bets: http://symmys.com/node/599